RISK MANAGEMENT MODULE B QUIZ 2

Credit risk appetite is operationalised through measurable limits on exposures, sectors, borrower groups, products and concentrations. Such limits help constrain risk-taking and should be monitored with escalation rules for breaches or emerging pressure.

Defined delegated authorities create accountability and ensure that higher-risk or larger exposures receive an appropriate level of scrutiny. They also reduce conflicts of interest and help prevent unauthorised approvals or inconsistent treatment of similar cases.

Underwriting should assess repayment capacity, borrower character/track record, capital and leverage, business conditions, collateral, loan purpose, tenor, covenants and sensitivity to adverse scenarios. No single factor should replace a comprehensive assessment.

Early warning signals include repeated payment delays, declining account turnover, deteriorating financial ratios, covenant breaches, adverse industry developments and overdue statutory dues. Timely action can help the bank engage the borrower and reduce loss severity before default.

Covenants set agreed requirements or restrictions, such as maintaining a leverage ratio or submitting financial information. They can prompt early engagement or remedial action when the borrower‘s risk profile changes, but require clear definitions and ongoing monitoring.

Collateral can improve recovery if a borrower defaults, but valuation uncertainty, legal enforceability, prior charges, market liquidity and time-to-realisation affect its value. The primary repayment source should generally remain sustainable cash flow.

Rating migration is a change in credit rating over time. A downgrade can signal increased default risk and may affect pricing, limits, provisioning/capital treatment where applicable, collateral requirements and monitoring intensity, even before an actual default.

If defaults are positively correlated, many borrowers may fail together during a common shock, increasing portfolio loss volatility and tail risk. A portfolio‘s risk therefore depends not only on each borrower‘s PD and LGD but also on exposure concentration and dependence between obligors.

Model validation examines conceptual soundness, data quality, assumptions, calibration, discriminatory power, stability and performance against outcomes. Independent review and ongoing monitoring are important because borrower behaviour and economic conditions change over time.

RAROC compares risk-adjusted earnings or returns with the capital allocated to absorb unexpected losses and support the activity, according to the institution‘s methodology. It allows businesses and transactions to be compared on a risk-aware basis rather than by nominal income alone.

Economic capital is an internal estimate of capital needed to support unexpected losses at a chosen confidence level and horizon, subject to the bank‘s framework. It differs from regulatory capital, which is determined by applicable rules, although both inform capital management.

Risk-based pricing commonly considers funding cost, operating cost, expected credit loss, capital cost and target return, while also considering market conditions and legal/regulatory requirements. Omitting expected loss or capital cost can make a high-risk loan appear more profitable than it is.

A credit derivative transfers or reshapes specified credit risk between counterparties without necessarily transferring the underlying loan or bond. Its effectiveness depends on contractual terms, counterparty performance, legal enforceability and the precise credit events covered.

The protection buyer pays a periodic premium to the protection seller. If a contractually defined credit event occurs and settlement conditions are met, the seller provides the agreed protection payment. The seller itself remains a counterparty whose creditworthiness matters.

CDS credit events are contractually defined and may include events such as failure to pay, bankruptcy or restructuring, depending on the reference entity and documentation. A general fall in a bond‘s market price alone is not automatically a credit event.

A TRS transfers the economic total return of a reference asset—such as interest, fees and price changes—to one party in exchange for an agreed financing or other return paid by the other. The reference asset need not be legally transferred to the total-return receiver.

A credit-linked note is a funded credit derivative: investors buy a note and their principal/returns may be affected by a specified credit event linked to a reference entity or portfolio. The structure transfers credit risk to investors, who bear the contractual losses if the trigger occurs.

A credit option gives the holder a right, but not an obligation, under specified terms to buy/sell credit protection or enter a credit-related transaction. Its value depends on the contract, reference credit quality, market variables and exercise conditions.

The protection seller may have to make a substantial payment if a covered credit event occurs. It therefore assumes exposure to the reference credit and may also face wrong-way risk, collateral/liquidity needs, legal and operational risks, and counterparty risks elsewhere in the transaction.

Post-disbursement monitoring includes reviewing repayment performance, account conduct, financial information, covenant compliance, collateral values, rating changes, industry conditions and early-warning indicators. It enables timely corrective action and is not replaced by the initial sanction assessment.